The Only Two Financial Stocks I've Ever Owned

This may come as a surprise, but I have only owned 2 financial stocks in my entire career: Raymond James Financial (RJF), and Annaly Capital (NLY). Mostly, I view financial stocks as highly levered black boxes. You cannot analyze a million loans that Citibank has made. Or the billions of mortgages on Bank of America's books that they got from Countrywide. It's simply impossible. In essence these are organizations built to leverage shareholders for the benefit of the employees. Work for them, don't ever own their stocks. That still remains true.

Coincidentally I just got the annual report from Raymond James yesterday, and at the same time got a nice dividend deposited in my account from Annaly Capital. Figured I would talk some about each, and why in almost 20 years of investing, I have never succumbed to owning anything else in the financial world. Although I do confess to being handed some Merrill Stock in my short time there as a bonus, it was yanked when I left. MER stock has since declined over 75% in a decade. My apologies to my hardworking friends there, they deserve better.

As for Raymond James, I have owned RJF stock non-stop since 1993. I worked at Raymond James back then, it being my first job out of college. Raymond James is regional investment bank, with a decent brokerage network, capital markets business, and asset management division.

It's a stock that is underfollowed, considered quite boring by the sellside, and tends to operate quietly but profitably in its own niches. Since they are an investment bank located outside of NY, generally they are considered second tier. Don't be fooled though. Top management, including the founder's son Tom James and his partner Bo Godbold, are Harvard Business School grads. Southern, but no dummies. They hire top talent there, the place is littered with HBS people. Today RJF trades around $36 a share, up from an adjusted price of $2 a share (split and dividend adjusted). I can't complain about an 18 bagger in 16 years. Even GS is only up 2.5x since it IPO'd 12 years ago.

Today I am not really advocating buying the stock. Honestly I would wait til it gets back to $30 a share. But given that only a handful of financial stocks in the entire country survived the 2008 meltdown, it's one to keep on your radar screen. I consider it a Buffet type play: management is almost boringly capable and conservative. They focus on generating high ROE type business such as advisory work, brokerage, and fee-based money management. And, best of all they eschew risky proprietary trading and leverage, the combination of which all but blew up Wall Street in 2008.

Throwing out just a few numbers, RJF has a book value of $19 a share, trades at $36 a share today and will do around $2.50 a share in EPS in 2011. That's a 14.4x multiple (or 7% FCF yield), and a big premium to the Goldman Sachs and Morgan Stanley's of the world. GS and MS trade around 8-10x 2011 earnings. Since RJF though only generates 30% of its pre-tax income from banking activities, and the rest from its fee-based businesses, its far less risky than almost any other bank out there. It's more like a T Rowe Price than a JP Morgan.

To illustrate how conservatively run the company is, take a look at Book Value per share and ROEs over the past 5 years. It even grew in 2008 throughout the crisis:

Book / Share
2006 $12.83
2007 $15.07
2008 $16.18
2009 $17.11
2010 $19.03

ROEs
2006 15.7%
2007 15.6%
2008 13.0%
2009 7.9%
2010 10.6%

As far as risk to the balance sheet, the biggest item is the $6BB of loans that the bank has made. The loans that are non-performing, or NPL's (in default, or over 90 days past due) adds up to $182mm. That's about 1.3% of the total. Further, they have already built up $147mm in loan reserves. Note that the loan allowance was $88mm in 2008, on a book of $7BB in total loans. So, compare that to today, $182mm on $6BB of loans. So you have some pretty conservative provisioning, and a potential improvement in earnings of up to $100mm should loan defaults continue to fall, and loan charge-offs normalize over time.

Considering that total net income was $228mm in 2010, its a big potential boost. On the flip side, if we get another recession, and NPLs rise, say another $75mm, that is only a 58c hit to the company's $19 book value per share. I am pretty sure that such a hit would be far higher to almost any big bank out there.

So, long term this is a decent play. We'll look for a dip to add. The trading mantra for this name is probably: buy it at 1.5x book, and sell it at 2.0x. That puts a buy price of $27 a share, and a sell price of $38 a share. Typical of this market, most names are fully valued.

So, on to Annaly Capital. I have followed and owned this stock off and on for years. I must have traded it at least a dozen times, within my old fund and within my personal account. It's probably the best performing financial stock in the past decade. Its stock chart isn't impressive, but in combination with the huge dividends it consistently pays out, it's been phenomenal. Since Jan 1, 2005, NLY has generated a total return of 66% through yesterday. Thats 6 years, call it up 10% a year on average. By comparison the financial index (XLF) is down from $30 a share, to $17 today. Disaster, down 43% in the same time period. All the massively levered banks were contributors to the declines: MS, MER, JPM, C, AIG et al et al.

So to back up, Annaly is a mortgage REIT. The name alone sounds scary given what happened to the real estate markets in 2008. But generally, management here buys Agency bonds: that is pools of Fannie Mae and Freddie Mac guaranteed mortgage bonds. They are implicity guaranteed by the US government. In fact, since the govt owns 80% of Fannie and Freddie now, they are all but explicity guaranteed by the government too.

So, Annaly essentially buys packages of your mortgages, called Agency MBS. They then borrow to buy more, leveraging themselves 6-7x. That is, on equity of about $10BB, they own $76BB of Agency bonds, borrowing the other $66BB. Most of their MBSs are fixed rate, plain vanilla 15- or 30-year mortgage paper. Only 16% of their portfolio of bonds is not fixed but rather in floating rate mortgages. Either way, defaults by homeowners has no impact on the payments of Agency bonds, Fannie or Freddie pay the interest no matter what.

Today, Agency bonds yield 4.1%, and it costs the company 1.95% to REPO them, or borrow money using them as collateral. So NLY's business model is very simple:

Interest Income: 4.1%
Interest Costs: 1.95%
Spread: 2.1%

Then they lever that spread above by 7x, meaning they make:
Spread 2.1%
X Leverage 7x
Total Return 14.4%.

Then they make the full interest income on bonds that they own outright. That is 4.1% above. So,
Levered Spread: 14.4%
Return on Bonds: 4.1%
Net Return: 18.5%

So ROE's track pretty closely to this number (although a little lower given OH and G&A costs). The problem with the stock is guessing which way mortgage yields (their assets), and REPO rates (their costs) will go.

Ok, so that gets to why Bill Gross recommended NLY. Basically, if REPO rates stay low, then borrowing costs stay low for Annaly. That is a good thing. REPO rates are ultimately driven by 2 things: market liquidity and the Fed Funds rate. This is all essentially Fed managed. With QE2 going on, liquidity is good. And the Federal Funds Rate right now is 0.25%. After yesterdays Federal Reserve meeting, low rates seem assured for some time.

So, clearly key is that the Fed doesn't raise rates. And the only thing that would make Bernanke lift rates is if we see inflation building. I am not a deflationist, ultimatey we'll get scary inflation. But not for at least 2-4 years. After all, it took Paul Volcker 3 years to quell inflation in the 1970s. And that was with massive Fed Funds hikes. It will take at least as long to get it going again. Unemployment is high, overcapacity is still a problem, and wage growth is pretty tame. Not to mention that the govt is manipulating the CPI data to show less inflation than there is. (another topic altogether!) So, on the whole, that means I can own NLY at today's price: $17.90 and be pretty comfortable its not going anywhere.

Another reason the Fed is virtually guaranteed to keep rates low is the state of our fiscal deficits. They HAVE to keep borrowing costs low. In effect the govt is financing our deficits by offering cheap money to banks. Who then turn around and buy Agencies and Treasuries. How do you think we are selling $1.4 Trillion in new treasuries every year to finance our deficits? Its not because foreigners (or anyone) for that matter actually thinks they are a good buy. Its because it's free money for the banks, who get Fed Repo financing, and turn around and buy long dated treasuries. (the classic carry trade, also helping to recapitalize the banks, the hidden subsidy).

Finally, lets discuss Annaly's dividends. At $0.64 a share, its current yield is 14.3%. Solid. It happens on occasion that the company raises equity capital, and they just did a deal earlier this month. Typically the stock gets beat up on dilution concerns (valid). So, with their fund raising out of the way for at least 4-6 months, perhaps longer, and with Fed Funds staying low for the next 2 years, I think this stock will be fine. Perhaps buy it on a dip if possible. Just don't look for any real price appreciation, all you will get is lots of cash back in the form of dividends. I'll take 14% a year though and be happy. And besides, what's better than cash?